Stock Offerings, Issue Costs, and Bank Debt Reductions

By Hull, Robert M. | Quarterly Journal of Business and Economics, Spring 2001 | Go to article overview

Stock Offerings, Issue Costs, and Bank Debt Reductions


Hull, Robert M., Quarterly Journal of Business and Economics


Introduction

Hull and Moellenberndt (1994) find that stock issues retiring bank debt have a market response about twice as negative as those retiring nonbank debt.' In this paper, we extend this research by seeking to learn if issue expenses can explain the difference in the market response. We do this by adjusting announcement period returns for the effects of issue costs. If issue costs are greater for firms that retire bank debt, then the differences found by Hull and Moellenberndt (1994) will be weakened.

The issue costs research (Hull and Fortin, 1994; Hull and Kerchner, I 996; and Hull and Kerchner, 2000) discovers that the impact of issue costs depends upon a variety of factors including the relative size of the offering, listing, and firm size. These findings suggest that we explore whether such factors might be more present in a sample of stock offerings that retire bank debt than in a sample of stock offerings that retire nonbank debt. If so, then issue costs can explain the difference in the announcement period response found when comparing the bank debt and nonbank debt reduction portfolios.

In this paper, we find that about half of the difference attributed to the type of debt being reduced can be explained by issue costs. Bank debt reductions tend to be undertaken by AMEX and OTC firms. These firms are smaller and are more likely to undergo greater changes in the relative size of the offering. As shown by issue costs researchers (Hull and Fortin, 1994; Hull and Kerchner, 1996; Hull and Kerchner, 2000), firms with these characteristics have greater issue costs and thus greater negative announcement period returns.

Competing Capital Structure Models

The stock-for-debt research (Peavy and Scott, 1985; Hull, 1994; Shah, 1994; Hull and Pinches, 1995; Hull and Mazachek, 2002) finds a significant negative stock valuation effect for stock-for-debt transaction announcements. The negative effect is consistent with capital structure models that predict negative tax, agency, signaling, and issue costs effects.

Tax models, rooted in Modigliani and Miller (1963), hypothesize negative stock price behavior when the debt reduction reduces a firm's debt tax shield. Agency models, based in Jensen and Meckling (1976), predict a negative stock market reaction when there is a net increase in agency costs. For stock-for-debt transactions, Galai and Masulis (1976) hypothesize a negative agency effect for shareholders if the cash flow payments to debt holders become less risky while payments to stockholders become more risky. Jensen (1986) also predicts a negative agency effect when reducing debt increases the monitoring costs associated with controlling managerial behavior.

Asymmetrical information signaling models predict that stock-for-debt transactions signal negative news. Leland and Pyle (1977) attribute negative signaling to decreases in the percentage of inside ownership caused when insiders do not participate in the new stock offering. Ross (1977) links the negative signaling to the reduction in debt. Decreases in debt convey negative information about a firm's ability to service current debt levels.

Models emphasizing the role of bankers as insiders (Kane and Malkiel, 1965; Bernanke, 1983; Fama 1985) argue that firms announcing bank debt agreements convey positive news. Bankers would not approve or extend a loan if inside information gotten in the lending process were negative. It follows that the market will suspect bank debt reductions are prompted by negative inside information. Thus, announcements of bank debt reduction should result in greater negative signaling than announcements of nonbank debt reduction.

Issue costs models suggest that stock offerings will result in a negative cash outflow to the announcing firm. Hull and Fortin (1994) show the extent of the negative cash outflow depends upon the costs per share issued and the relative size of the offering. …

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